Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Sunday, November 25, 2012

Road Trip!

A cross country drive…especially after an extended absence from
the U.S… adds unique perspective on the country’s economic condition that
evades one when solely slicing/dicing government data and reading investment reports.
And so it was last week as I ventured twenty hours across this vast land, always
remaining vigilant for clues on where the country lies along a bumpy recovery that
is occurring in the midst of a supposed rebalancing of the economy. The most obvious conclusion was evident every
time I exited the interstate anywhere near a city of moderate size and was
confronted by miles of big-box retailers and fast casual restaurants in all
directions. The lesson: despite efforts to deleverage and rebalance…both of
which take serious time…. economic growth is still largely wedded to the flawed
engine of consumers buying an exorbitant amount of crap.

True the recession had its share of casualties as strip
malls lost once high-flying tenants such as Borders Books, Circuit City and
Linen’s & Things.The carnage has
yet to end as electronics retailer Best Buy has plummeted 60% from its 52-week
high. The reason most cited is consumers shifting their shopping online and
consequently using physical retailers as showrooms for items to be purchased later
from the likes of Internet juggernaut Amazon.The premise is reflected in that firm’s share price, which sits only 10%
below its 52-week high and 44% above its low for the same period. Although this
transition is logical, analysts clearly don’t take into account technophobe
luddites like me who cannot buy an electronic toothbrush without having a sales
clerk walk me through every step of the instructions. I guess I am in the
minority.

The more important take-away is that the overwhelming growth
of retail space during the early 2000s is yet another sign of excess capacity
built up that must now be absorbed piecemeal into a (slow) growing economy.
Although the overhang in housing supply gets all the headlines, both are
products of the same go-go credit binge. After all, easy home equity loans and
subprime credit cards were key components in funding purchases of everything
from autos and home theaters to restaurant-quality appliances and naughty trips
to Vegas. Just as ground should never have been broken on many housing
developments, several retailers survived (and thrived) only because of the
loose financing offered to both their customers and to themselves, the latter of
which compensating for a level of cash flow insufficient to merit such growth.

The Long Shadow of
Keynes

One of the many ideas bestowed upon the study of economics
by John Maynard Keynes was the paradox of
thrift. While it is personally beneficial for an overextended individual to
pull back on the credit reigns, it is detrimental for everyone in an
overleveraged society to do so at the same time. The result would be a
precipitous drop in consumption, just when the economy likely needs a boost to
growth. The U.S. is acutely exposed to such a phenomenon given its reliance on
personal consumption (70% of GDP). A recent report by Transunion shows that the
balances the average borrower carries on his/her credit card fell 23% from its
peak in early 2009 to the recent trough in 2011. Since then balances have
clawed back 7%, just nipping $5,000. (We shall save for another day the
insanity of carrying such a balance on a source of financing with notoriously
high interest rates).

A slight bump in credit card balances may cause economists
worried about Keynes’s paradox to sleep a touch more easily, but other evidence
shows deleveraging may continue to provide headwinds to economic expansion. At
its peak, the rate of household debt to disposable income reached north of 130%.
Economists believe 100% is the maximum sustainable level, and the U.S.’s
long-term average is in the neighborhood of 70%. Recent government data pins the
current rate at just above 100%. Should
consumers either desire to cut down on debt further, or not be approved for
additional credit, then the economy will need to find another source of growth
to compensate for tepid personal consumption. A banking survey conducted by the
Federal Reserve shows that after a period of extreme increases in lending
standards for products like credit cards, banks have slowly begun to loosen requirements,
although they remain much tighter than during the credit boom.

Black Friday and
Black Eyes (to Shoppers and Bottom Lines)

The mentality of the consumer is especially important as the
retail sector is immersed in its most important period of the year. Retailers
may need a stellar holiday season to account for what has otherwise been a
lackluster year when compared to earlier stages of the recovery. Year-on-year
growth in retail sales (ex-autos) have been mired below 5% for the past seven
months. In 2011, every month registered YOY gains greater than 5%.

Despite this record, retailers continue to outperform the
broader stock market. Yes the boost in credit demand and availability may be
positive signs, as is a robust post-Thanksgiving weekend (despite the inevitable
muggings, tramplings, and knife-fights over video game consoles), but during
each holiday season of this mediocre recovery, store managers are faced with
the tough decision of garroting profit margins in an effort to lock in early
sales or risk losing market share to cutthroat competitors, especially those of
the online variety.

Which Way from Here?

If these themes sound familiar, it is because they are the forces
the economy has been dealing with since 2009, as it attempts to return to
historical growth rates (I’ve all but given up on experiencing a period of
above-trend growth to compensate for pent-up demand delayed during the
recession). Consumers hesitate to ramp up credit-fueled spending. Construction,
both residential and commercial (think big-box), likely won’t be a strong
contributor given the excess capacity of space in both segments. And
corporations, by sacrificing profitability for the sake of simply moving
product, will have to cut expenses somewhere and it’s a good bet headcount is a
likely candidate, as it always is. Furthermore, contracting profit margins will
inevitably spook investors thus offsetting any of the heady wealth-effect that
the Fed so desires to create with its torrent of easy money searching for a
home, often the stock market. On top of these question marks, should a deal not
be reached, consumers stand to get whacked with brutal tax increases come
January 1st. Such an outcome….which is within the realm of plausibility….would
quickly undo the marginal gains the economy has made over the past several
quarters. Stay tuned. And maybe brush up on canning vegetables.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.